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A deal to extend the debt ceiling and reopen the government is emerging. If it passes by tomorrow or shortly thereafter, the economy and markets will be spared the worst case scenario of a technical default. However, Washington’s inability to strike a more substantial bargain will have negative repercussions, over both the short and long term.

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A deal to extend the debt ceiling and re-open the government is emerging. Assuming it passes by tomorrow or shortly thereafter, the economy and markets will be spared the worst case scenario of a technical default.

However, Washington’s inability to strike a more substantial bargain will have negative repercussions, both over the short and long-term. It is an all too familiar script: several near-death experiences followed by a minimalist solution which avoids catastrophe, but fails to address the underlying problem. Events in Washington have again followed that pattern.

As of Wednesday afternoon, a deal that can pass both the House and Senate is not assured, but the broad outlines of a solution – a four -month extension of the debt ceiling and a short-term resolution to re-open government – are forming. Of course, given the realities of negotiating both the House and Senate, any bill may not be signed prior to the official October 17th deadline, but to the extent that the government can probably fund itself for a few extra days, investors may look past the “official deadline”, thus averting a bigger market correction.

While avoiding the worst, Washington’s inability to arrive at a more permanent solution will add to the corrosive effect for both the near and long term of other recent budget battles.

The Short Term

In the near-term, the tardiness and temporary nature of the deal will produce some drag on the economy, heighten volatility, and probably produce some modest drag on Q4 earnings.

Starting with the economy, economists have already shaved estimates of Q4 GDP from 2.30% to 2%. To the extent that consumer confidence, as well as business confidence, remains depressed, this may still be too high. If growth does disappoint, earnings for Q4 are arguably too high as well. Second, lingering uncertainty over the next act of the drama, which will unfold in early 2014, is likely to keep market volatility elevated relative to the summer’s more placid levels. Finally, the dysfunction in Washington has not gone unnoticed outside the United States. While the fundamentals remain positive, we may see further dollar weakness in the near-term, particularly if uncertainty over the fiscal situation leads to a slower pace of Fed tapering.

The Longer-Term

The longer-term consequences are less certain, but we can make a few guesses.

The underlying political divisions will still be with us in early 2014; we may be looking at a series of short-term deals and patches rather than a longer-lasting budget solution. If next year’s mid-term elections maintain the status quo — bitterly divided government and heightened partisanship — this may become a depressingly familiar pattern over the next three years.

And while the fiscal position is improving in the near-term, thanks to higher tax revenues and some slowing in discretionary spending, it starts to deteriorate again by the end of the decade. This suggests that any stabilization in the debt-to-GDP ratios may be temporary, a troubling prospect given that, as Fitch highlighted in its recent announcement, the United States remains “the most heavily indebted ‘AAA’ rated sovereign, with a gross debt ratio equivalent to double that of the ‘AAA’ median.”

Given this outlook, what changes, if any, should investors consider in their portfolios?

To start, and arguably the silver lining of this whole debacle, the Fed is likely to maintain an accommodative monetary environment for longer. This suggests a slower backup in interest rates. An environment of range bound rates and slow growth is still supportive of high yield.

Another likely beneficiary is mortgage backed securities. Given the risk for softness in consumption, the economy is even more dependent on housing. The Fed knows this and is likely to try to put a cap on mortgage rates, making longer Agency MBS attractive.

Finally, investors who have not already done so should bring down their US overweight. Over the past three-months, international markets have outperformed the US by over 500 basis points. A weaker dollar and no taper could also be supportive of emerging markets.

Source: Bloomberg

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his postshere.

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Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. Mortgage-backed securities (“MBS”) represent interests in “pools” of mortgages and are subject to credit, prepayment and extension risk, and therefore react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of certain MBS.

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations.

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